Is the Section 45 renewable energy production tax credit reduced for an issuer that issues taxable New Clean Renewable Energy Bonds (“New CREBs”)? Do New CREBs constitute “subsidized energy financing” within the meaning of Section 45(b)(3)(A)(iii)? Certain rumors suggest that the Department of the Treasury will be issuing a notice or ruling of some type in the near future clarifying this point. The probable conclusion may indicate that New CREBs are to be considered “subsidied energy financing.”

The production tax credit was authorized by the Energy Policy Act of 1992 and is considered the most significant factor behind the growth of utility-scale wind energy. The credit is currently 2 cents per kilowatt-hour on corporate income tax for electricity generated by qualified energy projects. The credit is available for the first ten years of operation and is adjusted annually for inflation.

For a general overview of Section 45 production tax credits and Section 48 investment tax credits, see this presentation by Greenberg Traurig. For a general discussion of investment tax credits and renewable energy production tax credits, see also IRS Notice 2009-52.

Statements regarding backup withholding and reporting are common in official statements relating to tax-exempt bonds. Such statements have also appeared in official statements relating to taxable bonds such as Build America Bonds. This post provides a basic overview of what backup withholding (and reporting) means for purposes of tax-exempt and taxable bonds. Portions of the following description are taken from a McGuireWoods news letter posted here.

Section 6049 of the Code requires “payors” to file information returns with the IRS showing interest payments. These information returns are required to assist taxpayers and the IRS in determining a taxpayer’s correct tax liability. The returns are made on IRS Form 1099-INT.

Section 3406 of the Code subjects reportable interest to backup withholding, which means that a payor must institute a backup withholding on a payee who fails to properly certify (a) the payee’s federal TIN, (b) that the payee is not subject to backup withholding and (c) that the payee is a U.S. citizen. Such certifications are usually made on IRS Form W-9.

In the past, interest on tax-exempt bonds, notes, installment-sale and lease-purchase agreements, capital leases and similar obligations issued or incurred by state or local governmental units (all tax-exempt) was not subject to reporting under Section 6049 of the Code and not subject to backup withholding under Section 3406 of the Code. In other words, such tax-exempt obligations were exempt from reporting and withholding.

Under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), however, Congress removed this exemption. Therefore, unless another exemption applies, all tax-exempt interest paid after December 31, 2005 on any tax-exempt bond, regardless of the date of issuance of the bond, is subject to the reporting and backup withholding requirements.

“Payor” means, within the meaning of the Income Tax Regulations, a person who (a) makes a payment of tax-exempt interest to any other person during a calendar year or (b) who collects on behalf of another person payments of tax-exempt interest, or who otherwise acts as a “middleman” with respect to such payments. See also Section 1.6049-4 of the Income Tax Regulations.

“Middleman” means, within the meaning of the Income Tax Regulations, any person, including a financial institution, a broker or a dealer, or a nominee, who makes payment of interest for, or collects interest on behalf of another person or otherwise acts in a capacity as intermediary between a payor and a payee. See also Section 1.6049-4 of the Income Tax Regulations.

No information return is required with respect to any payment made to an “exempt recipient.” “Exempt recipient” includes corporations, tax-exempt organizations (including 501(c)(3) organizations), the federal government, any state or the District of Columbia, or any political subdivision thereof, financial institutions, nominees or custodians, and securities dealers and brokers. Exempt recipients do not include individuals, partnerships or any entity that is taxed as a partnership for federal tax purposes. Interest paid by a municipality to a financial institution which is the holder of the related bond would, therefore, not require the municipality to provide IRS Form 1099-INT to the financial institution.

Portions of the above description were taken from a McGuireWoods news letter posted here, titled “Update on New Reporting Requirement for Tax-Exempt Interest” dated March 27, 2007.

Apparently, the first drafts of TIPRA included a provision that would have required municipalities to report interest earned by bondholders to the IRS. This provision was removed in the version of the act adopted by Congress. This effectively clarifies that a municipality generally is not required to report and take backup withholding measures.

The general Reasonably Required Reserve and Replacement Fund (4-R Fund) is set forth in Section 148(f)(d) and Section 1.148-2(f)(2):

Section 148(f)(d):

(1) In general. For purposes of subsection (a) (“Arbitrage Bond Defined”), a bond shall not be treated as an arbitrage bond solely by reason of the fact that an amount of the proceeds of the issue of which such bond is a part may be invested in higher yielding investments which are part of a 4-R Fund. The amount referred to in the preceding sentence shall not exceed 10 percent of the proceeds of such issue unless the issuer establishes to the satisfaction of the Secretary that a higher amount is necessary.

(i) In general. The investment of amounts that are part of a reasonably required reserve or replacement fund in higher yielding investments will not cause an issue to consist of arbitrage bonds. […] Amounts in a 4-R Fund in excess of the amount that is reasonably required is not part of the 4-R Fund.

(ii) Size limitation.

[A qualifying 4-R Fund] may not exceed an amount equal to the least of [a] 10 percent of the stated principal amount of the issue [note the special de minimis rule on how to calculate this], [b] the maximum annual principal and interest requirements on the issue, or [c] 125 percent of the average annual principal and interest requirements on the issue.

If an issue has more than a de minimis amount of OID or OIP (OID or OIP exceeds two percent times the stated redemption price of the bonds), the “issue price” of the issue (net of pre-issuance accrued interest) is used to measure the 10 percent limitation in lieu of its “stated principal amount.”

For a 4-R Fund that secures more than one issue (e.g. a parity reserve fund), the size limitation may be measured on an aggregate basis.

Amounts in excess of the limit set forth in the three-prong test may not be invested at a materially higher yield, otherwise yield reduction payments must be made.

B. Discussion

Section 148(d) and section 1.148-2(f)(1) of the regulations provide two general rules for reserve funds:

Don’t put more than 10% of the “sale proceeds” of an issue into a “reserve or replacement fund” and

If a reserve or replacement fund is “reasonably required,” the issuer may invest sale proceeds or replacement proceeds in it without yield restriction.

The second rule is an exception to yield restriction and is not a rebate exception! There are no exceptions to rebate for reserve funds, except for the broad small issuer $5 million exception applicable to all proceeds generally.

A “reasonably required” reserve or replacement fund is one that meets the three prong test identified above under the regulations. This test was first incorporated by Rev. Proc. 84-26. Discussions on this test follow:

1. The 10% prong is based generally on the stated principal amount of the issue.

If bonds are issued at prices that differ from their stated principal amount by more than a de minimis amount, the regulations require the 10% test to be based on issue price at technically defined (1.148-1(b)). De minimis means 2%. So, if stated principal is $10 million, issuer uses $1 million (which here assumed to satisfy the other prongs). If bonds are actually sold at a discount of 1 percent, the technical definition of issue price is $9.9 million. The issue price is less than 2% different from that used to calculate the $1 million, so the issuer is protected and satisfies the 10% prong.

The de minimis rule also applies to premiums. An original issue premium is de minimis if it does not exceed (a) 2% of principal plus (b) any portion of the original issue premium that is attributable to reasonable compensation for the bond underwriters.

The 10% test applies to the original amount of the issue and does not change during the life of the issue as the issuer pays off principal.

2. Maximum Annual Debt Service

This prong may refer to debt service on bonds remaining outstanding, but see Question 5 below.

3. 125% of the average annual debt service on the issue

This prong may refer to debt service on bonds remaining outstanding, but see Question 5 below.

C. Example Language

Based on the representations of the Underwriter in the Certificate of the Underwriter attached as Exhibit __ hereto, the Reserve Fund is an essential element in the marketing of the Bonds, and as provided in such Certificate of the Underwriter, the amount of the Required Reserve does not exceed the lesser of (a) 10% of the stated principal amount of the Bonds, if the original issue discount does not exceed 2% times the stated redemption price of the Bonds, or 10% of the Issue Price, if the original issue discount does exceed 2% times the stated redemption price of the Bonds, (b) the maximum annual principal and interest requirements of the Bonds or (c) 125% of the average annual principal and interest requirements with respect to the Bonds

D. Questions and Answers

Question 1: Assuming there are two series (considered one issue for tax purposes) and two reserve funds – one for each series – that are not parity reserve funds, must each reserve fund satisfy the 4-R Fund tests individually? Yes. Compare to Section 1.148-2(f)(2)(ii) of the Regulations relating to parity reserve funds.

Question 2: Can the borrower increase the amount deposited to a 4-R Fund with non-proceeds/equity contributions? There is a strict limit of 10% from bond “sale proceeds.” Non-proceeds in excess of this would probably be yield restricted but could qualify for yield reduction payments if the amount, when added to proceeds, does not exceed 15% of the issue price of the bonds. See Section 1.148-5(c)(3)(i)(E) of the Regulations and page 69 of the 2007 Fundamentals of Municipal Bond Law. What happens if that percentage goes above 15%? Section 1.148-5(c)(3)(i)(E) of the Regulations states that yield reduction payments in this case cannot be made with respect to that portion of the reserve fund over the 15% limit. (The portion within the 15% limit still qualifies for the yield reduction payments.)

See PLR 8351138 concerning a discussion of the 15% limit, the exception permitting a larger reserve fund so long as a ruling is requested and received, and overissuance discussion. (*)

Question 3: Assuming there is one 4-R Fund securing more than one issue (so-called “parity” reserve fund), must the size limitation be measured on an aggregate basis? Yes. Section 1.148-2(f)(2)(ii) of the Regulations states that “for a reserve or replacement fund that secures more than one issue (e.g., a parity reserve fund), the size limitation may be measured on an aggregate basis. In reality, it would be best to also measure on an issue by issue basis. In other words, test the reserve fund twice: Once against the individual issues, and once against the aggregate.

Question 4: Must the reserve fund, to be a 4-R Fund, at all times meet the three-prong test? The first prong (10% of bond size) can never change over time. The results from the other two prongs can change. This means, at all times will these two prongs be met.

Question 5: Are the three prongs tested only at closing, or are they tested throughout the life of the bonds? Ballard in his ABCs of Arbitrage on page 40 (2007 edition) talks about how the regulations are not explicit on whether the MADS and 125% tests refer to debt service on bonds remaining outstanding or only upon issuance and goes on to talk about what happens if the reserve fund does suddenly become overfunded. Legalistically, this is correct. But realistically you figure out what would be required for a fixed rate issue and that is the amount you are allowed. It doesn’t change as the rate changes or the bonds are paid down (same as for a fixed rate that is amortized over the life of the bonds).

Question 6: What if the reserve fund is funded solely from equity contributions? What are the yield restriction rules? The 10% limit applies only to the use of “sale proceeds” of the bonds (see 1.148-2(f)(1)). According to Mr. Ballard (page 39), an issuer can create a reserve fund using revenues instead of proceeds of the bond sale. A reserve fund of this type would be subject to the arbitrage rules as replacement proceeds. It can qualify for unrestricted investment under the same test of reasonableness as a reserve fund created with sale proceeds. That test is the three prong test.

Question 7: How do the Reasonably Required Reserve or Replacement Fund tests work with General Obligation Bonds or Annually Appropriated Leases? Any fund that is intended to be a 4-R fund must be “reasonably required.” Meeting the three-prong test is a strong indication of reasonable requirement. The Underwriter will generally also certify that the fund is reasonably necessary to sell the bonds. However, the IRS could find that, under all facts and circumstances, the fund is not reasonably required even if the three prong test is met. In Rev. Proc. 84-26, the IRS suggests that a reserve for General Obligation Bonds might not be reasonably required (although, as Frederic Ballard indicates, “it is easy to imagine circumstances in which a reserve fund for G.O. bonds would be entirely reasonable, such as when the bonds are required to have a reserve fund to obtain insurance”). It may also be reasonable to have a reserve for G.O. bonds where the assessed value of property underlying the general obligation pledge may fluctuate highly. The issuer may be required to provide evidence of this fluctuation and a certification as to reasonable necessity. The determination, therefore, for purposes of reserve fund tests, must be made not only on the basis of the three prong test, but also based on the facts and circumstances surrounding the reasonable necessity.

Is it reasonable to have a reserve fund for an annually appropriated lease (with or without certificates of participation)? The annual appropriation is an appropriation from the general fund. Unless there are factors otherwise supporting the use of a reserve fund, it does not appear that a reserve fund is reasonably needed – if the lessee appropriates, the appropriation is in full and there is no need to rely on a backstop; if the lessee fails to appropriate, the default provisions kick in. Examples where a reserve might be reasonable include variable rate leases where the appropriation for the year may not anticipate significant increases in rates during the year. Alternatively, a reserve fund might be reasonable if the reserve fund is required to sell the certificates. In addition, a reserve fund can be used if it is funded with a reserve policy instead of proceeds.

Question 8: How is the 3-prong test applied to bonds with balloon maturities? There are no special rules or changes to how the 3-prong test is applied to bonds with balloon maturities, even though it might appear that these bonds unnaturally satisfy the MADS test and perhaps even the the 125% AADS test. Don’t worry. Be happy.

Issue:

When is interest on tax-exempt bonds subject to the alternative minimum tax?

Discussion:

Pursuant to I.R.C. § 55, a tax is imposed (the “alternative minimum tax”) in an amount equal to the excess of the “tentative minimum tax” (TMT) over the taxpayer’s “regular” tax liability (reduced by certain tax credits) for a given taxable year. If the TMT is greater than the regular tax liability, the alternative minimum tax is imposed in addition to the regular tax liability. If the TMT is less than the regular tax liability, the taxpayer will not need to pay the alternative minimum tax. The alternative minimum tax is in addition to the regular tax liability and not an “alternative” to the regular tax liability.

The calculation of TMT differs for noncorporate taxpayers and corporate taxpayers, and incorporates certain exemption amounts that may differ from year to year:

(a) For noncorporate taxpayers, the TMT is equal to (i) 26% times the excess (up to $175,000) of the alternative minimum taxable income (AMTI) over a certain exemption amount, plus (ii) 28% times such excess over $175,000.[1]

(b) For corporate taxpayers, the TMT is equal to (i) 20% times the excess of the AMTI over a certain exemption amount, less (ii) certain alternative minimum tax foreign tax credits.

The basic calculation for AMTI is the same for noncorporate and corporate taxpayers. The AMTI is equal to the taxpayer’s “regular” taxable income for the taxable year, but is (a) adjusted based on additions and deductions required by I.R.C. §§ 56 and 58 and (b) increased by the amount of certain tax preference items described in I.R.C. § 57. For the taxpayer, the goal is to reduce the AMTI as much as possible such that, under the TMT calculation, TMT turns out to be less than or equal to the regular tax liability.

One of the adjustments required by I.R.C. § 56 for individuals is the inclusion of tax-exempt interest received on “specified” private activity bonds. In other words, even though such tax-exempt interest is not included in the “regular” taxable income, solely for purposes of determining AMTI, individuals must include such interest. This inclusion increases the AMTI and therefore increases the likelihood of becoming subject to the alternative minimum tax. This adjustment for tax-exempt interest is not required for tax-exempt interest on “governmental bonds” such as school district bonds or on “qualified 501(c)(3) bonds” such as certain charter school bonds. Therefore, the individual does not need to increase AMTI by the interest it receives from, e.g., school district bonds or charter school bonds.

The foregoing adjustment for individuals does not apply to corporate taxpayers. Instead, I.R.C. § 56 requires, among other adjustments, an increase in the corporation’s base AMTI by 75% of the excess of (a) the adjusted current earnings (ACE) of the corporation over (b) the base AMTI.[2] ACE is equal to the base AMTI plus or minus certain other adjustments. In other words, the corporate taxpayer starts with the base AMTI (which already includes some adjustments such as special calculation of net operating loss and other items that are not relevant to this memorandum) and adds 75% of any ACE adjustment above the base AMTI. One of the ACE adjustments is an addition for tax-exempt interest on all non-housing bonds.[3] This means that 75% of the tax-exempt interest on such non-housing bonds is added to the base AMTI. When the AMTI increases as a result of this addition, there is a greater likelihood that the TMT will be larger than the taxpayer’s “regular” taxable income. This ACE adjustment may therefore subject the taxpayer to the alternative minimum tax.

(Note that the alternative minimum tax discussion above relates only to tax-exempt interest. Interest on, e.g., taxable build America bonds or tax credit bonds, is taxable and would never be excluded in the calculation of the taxpayer’s “regular” tax liability. Therefore, no special AMTI or ACE adjustments are relevant for such taxable interest.)

[1] The $175,000 threshold is lowered to $87,500 for married individuals filing a separate return.

[2] ACE turns out to be less than the base AMTI, the Code permits the final AMTI to be reduced rather than increased, subject to certain thresholds.

[3] Interest on housing bonds was permanently excluded from this calculation in 2008. Interest on all other bonds issued between 2009 and 2010 was temporarily excluded. Bond counsel typically used special “TAX MATTERS/EXEMPTION” and tax opinion language for bonds issued during those years to refer to the temporary exclusion.

Special AMT Rules for Refunding Bonds:

Special rule for refunding bonds: I.R.C. 57(a)(5)(iv) states that interest on “specified private activity bonds” (reduced by any deduction (not allowable in computing regular tax) which would have been allowable if such interest were includible in gross income) is an item of tax preference for purposes of AMT. “Private activity bonds” does not, however, include any refunding bond (whether current or advance) if the refunded bond (or in the case of a series of refundings, the original bond) was issued before August 8, 1986. For this purpose, “refunding bond” is an issue the proceeds of which are used to pay principal, interest and call premium on the prior issue and the qualified administrative costs associated withe refunding. Unlike Section 1313(a) of the 1986 TRA, there is no requirement that the par amount of the refunding bond be equal to or less than the par amount of the refunded bond. See also Title VII, 2 of the 1986 Blue Book.

Section 103(a) of the Code excludes from gross income for federal income tax purposes interest on any “State or local bonds.” A bond is defined as an “obligation” of any State or political subdivision thereof. For an obligation to exist for Section 103 purposes, it must be incurred by an issuer (see section B below) pursuant to the exercise of its borrowing power, as opposed to some other power, and the bonds must be valid under state law (see section D below). The following sections provide a discussion of certain of these requirements.

B. ISSUER STATUS

1. States and Political Subdivisions

A political subdivisions, for purposes of Section 103, is a governmental unit to which there has been delegated at least one of the three fundamental sovereign powers of the state. (See also PLR 201104020)

Three generally acknowledged sovereign powers of states are the power to tax, the power of eminent domain and the police power (power to regulate). See Estate of Alexander J. Shamberg, 3 T.C. 131 (1944). It is not necessary that all three powers be delegated. However, possession of only an insubstantial amount of any or all sovereign powers is not sufficient. “All of the facts and circumstances must be taken into consideration, including the public purposes of the entity and its control by a government.” See Rev. Rul. 77-164. See, also, Philadelphia National Bank case cited below (the Temple University case).

PLR 8152063: Entity given power of eminent domain and the right to condemn property to improve health conditions of the state.

PLR 9122068: University has eminent domain and police powers for campus police.

PLR 8630027: District’s powers do not represent substantial powers of taxation or eminent domain. In effect, here the District (wholly controlled by the non-exempt Corporation) has been delegated no materially greater ‘sovereign powers’ over District land (the Corporation’s inventory) than the Corporation inherently will have if the District is never created.

PLR 201104020: The issuer is not a political subdivision because it’s power of eminent domain is limited in that the issuer must seek approval from the City Council before exercising the power. This was found to be only an insubstantial amount of sovereign power.

Rev. Rul. 77-164: A community development authority, created under state laws that empower it to collect service and user fees for the construction, operation and maintenance of community facilities, that lacks the power to tax, the power of eminent domain and control over zoning, police and fire protection, does not qualify as a political subdivision within the meaning of I.R.C. 103.

PLR 200238001: A district is governed by property owners and elected officials of the County. The IRS reviews sovereign powers and then the division test. The IRS concludes that, because at least five (presumably the majority) trustees of the board “are subject to the control of either the County Judge/Executive, an elected official of the County or the control of the property owners of the District.” This suggests that, if all trustees were subject to the control of the property owners, that would be sufficient. There is no sense in this PLR that the property owners cannot be the owner of all of the property within the district.

PLR 200017018 (Wholly motivated by a public purpose): Request for ruling that the Authority is a political subdivision of the state. The Authority was created under state law by local governmental units A, B and C, to provide for the development of ports for transportation-related commerce. The Authority is governed by a board of directors appointed by its member governmental units. Upon dissolution, the Authority’s assets will be distributed to its member governmental units. “In determining whether an entity is a division of a state or local governmental unit, important considerations are the extent the entity is (1) controlled by the state or local government unit, and (2) motivated by a wholly public purpose. […] Indicia that the Authority is governmentally controlled are: (1) the Authority is governed by a board of directors appointed by its member governmental units A, B and C; (2) the Authority’s net revenues inure to the benefit of the State and its municipalities; and (3) the Authority’s assets will be distributed to its member governmental units upon dissolution. The Authority is motivated by a wholly public purpose.” Accordingly, the Authority is a political subdivision for purposes of I.R.C. 103.

“Public purpose” in the context of a wholly public purpose: See Treas. Reg. 1.141-5(d)(4)(ii): “Essential governmental functions. For purposes of paragraph (d) of this section, improvements to utilities and systems that are owned by a governmental person and that are available for use by the general public (such as sidewalks, streets and street-lights; electric, telephone, and cable television systems; sewage treatment and disposal systems; and municipal water facilities) serve essential governmental functions. For other types of facilities, the extent to which the service provided by the facility is customarily performed (and financed with governmental bonds) by governments with general taxing powers is a primary factor in determining whether the facility serves an essential governmental function. For example, parks that are owned by a governmental person and that are available for use by the general public serve an essential governmental function. Except as otherwise provided in this paragraph (d)(4)(ii), commercial or industrial facilities and improvements to property owned by a nongovernmental person do not serve an essential governmental function. Permitting installment payments of property taxes or other taxes is not an essential governmental function.”

PLR 201735020 (Police Power): Division established by State as part of State’s public transportation system was held to be a political subdivision. Division is governed by a board of directors the members of which are appointed by the governing bodies of the counties in the metro area and by the chief executive official of a city. Board members can be removed for cause by a majority of board members or by the governor of State. Division has certain powers which the IRS considers to be substantial police powers. Ruling incorporates the flawed IRS conclusion that a political subdivision must be a division of a state or local government. Specifically, the ruling unduly focuses on the specific public purpose of Division and control by State and certain other governmental entities.

PLR 201741010: Corporation established to provide long-term energy solutions and maximize the value of natural gas located in the state for its residents determined to be a political subdivision under section 103.

2. “On Behalf Of” Issuers: Overview

If an entity fails to satisfy the requirements necessary to be treated as a political subdivision, it may still issue tax-exempt obligations if in so doing it is deemed to be acting on behalf of a state or local governmental unit. See Rev. Rul. 77-164; Philadelphia National Bank v. United States, 666 F.2d 834 (3d Cir. (Pa.) 1981).

There are two types of “on behalf of” issuers: (1) entities formed under state law for the express purpose of issuing bonds to effect a public purpose, i.e., constituted authorities; and (2) entities formed under applicable state nonprofit corporation law which comply with the requirements of Rev. Rul. 63-20. Rev. (Proc. 82-26 sets forth the conditions under which the IRS will grant a favorable advance ruling on whether a nonprofit corporation’s obligations are exempt under Code Section 103(a)(1).)

Don’t confuse “on-behalf-of” issuer status (discussed in this posting) with “instrumentality” status (discussed in this posting). Instrumentality status is only relevant to determining whether the entity is “governmental person” for purposes of the private activity bond test (and for charitable contributions and FICA taxes).

For a good overview of “on behalf of” issuers, see George Pitt’s “63-20 Handbook.

Constituted authorities are entities specifically authorized by state law to issue bonds on behalf of political subdivisions of a state, among other specific powers granted to such entities in order to further public purposes.

Alabama board ruling (Rev. Rul. 57-187): Describes that obligations by this entity were deemed issued on behalf of the political subdivision. Nearly all conduit public authority enabling legislation is based on Rev. Rul. 57-187.

There is generally no difference for federal tax purposes between an issuance by the political subdivision and the issuance by an on-behalf-of constituted authority.

Statutes can include municipal ordinances enacted under a home rule charter, but do not otherwise include intergovernmental agreements, as described in a private letter ruling of the mid-1980s. The statutory reference to the “constituted authority” must be fairly specific and, for example, should refer to the authority by name or be otherwise specific to the authority. One Chicago-based bond counsel firm apparently requested a ruling regarding constituted authority status in a western state which had a liberally-worded statute. The IRS proposed or even issued an adverse ruling.

Rev. Rul. 57-187: Industrial development boards were authorized by state law for incorporation in municipalities to promote industry and develop trade in Alabama. In furtherance of those purposes the boards were empowered to acquire, improve, furnish, equip, lease, sell and convey industrial projects and to issue bonds in furtherance of the boards’ purposes. The boards were controlled by the local municipality’s governing body. State law provided that bonds were payable solely out of revenues from the boards, sales or lease of projects. Each board was a public nonprofit corporation whose earnings and property upon dissolution reverted to the municipality in which it was located. The IRS ruled that bonds issued by the industrial development boards were obligations issued “on behalf of a political subdivision” by a constituted authority. Characteristics in Rev. Rul. 57-187: (1) the issuance of the bonds must be authorized by specific statute; (2) the bond issuance must have a public purpose (which includes promotion of trade, industry and economic development); (3) the governing body of the authority must be controlled by the political subdivision; (4) the authority must have the power to acquire, lease and sell property and issue bonds in furtherance of its purposes; (5) earnings cannot inure to the benefit of private persons; (6) upon dissolution, title to all bond financed property must revert to the political subdivision.

Rev. Rul. 60-248: Bonds, notes, and other obligations issued by the New York State Housing Finance Agency, established pursuant to an Act of the New York State Legislature for the purpose of ﬁnancing the construction of low rent housing facilities, are considered as issued on behalf of the State and the interest received therefrom is exempt from federal income tax. Agency’s membership consists of the State Commissioner of Housing, the State Director of the Budget, the State Commissioner of Taxation and Finance, and two other members appointed by the Governor. The Governor may remove any member of the Agency for ineﬃciency, neglect of duty, or misconduct in oﬃce. The Agency and its corporate existence are to continue for as long as it shall have bonds, notes, and other obligations outstanding, and until its existence is terminated by law. Upon termination, all its rights and properties shall pass to and be vested in the State of New York.

PLR 201104020: Authority was not an on-behalf-of issuer because a majority of the board members was not controlled by the City.

PLR 200936012: Corporation’s board is appointed by the County. Corporation meets the requirements of Rev. Rul. 57-187 as an on-behalf-of issuer.

TAM 200646017: Public school academy doesn’t have sovereign powers (though it does meet the division analysis, particularly because of the control element) but is an on-behalf-of issuer of the state because it meets the requirements of Rev. Rul. 57-187.

PLR 8912008: University issues bonds on behalf of the state.

PLR 8906058: Authority created under state law to assist with planning and development of the county issues bonds on behalf of the county.

PLR 8542104 (Jul. 29, 1985): Authority is created by City ordinance pursuant to a state statute to issue bonds for creation of certain public facilities. Bonds will be issued on behalf of the City, which approves the Authority’s Articles of Incorporation, provides for perpetual existence and distribution of assets to City in event of dissolution. The City has the right to appoint and remove Board of Directors. The City’s home rule status causes the ordinance to be considered state statute for purposes of creation of the Authority. Authority therefore is a constituted authority. (“Focus on the Family ruling.”)

PLR 8507034: IRS held that a housing finance joint powers board was not a “constituted authority” within the meaning of Treas. Reg. 1.103-1(b) because the statute under which the board was created did not specifically authorize the board to issue obligations on behalf of a state or local governmental unit for a specific purpose. Instead, the statute generally permitted the board to issue bonds under any law under which the governmental units were independently authorized to issue bonds.

PLR 8419029: Lease purchase financing entered into by entity is considered entered into on behalf of the university even though not all of the entity’s board members are controlled by the university – a majority is sufficient.

PLR 8405131:

PLR 8232044:

PLR 8215025:

PLR 8207036: The IRS rules that an entity organized by more than one municipality does not affect the application of the criteria in Rev. Rul. 57-187.

PLR 8139124: Board is a department of the state responsible for advising the state regarding supervision of aeronautics within the state. The authorizing act for the board authorizes the board to issue bonds on behalf of the state to finance projects suitable for use by commercial enterprises that provide scheduled air transportation services within the state. Without any analysis, the Service concludes that the board is an on behalf of issuer of the state. Side issues in the ruling are the requirement for locating small issue bond facility within the jurisdiction of the issuer where the financed property may travel outside of the jurisdiction. The project consisted of aircraft.

PLR 8125023: The Authority was established in County Y by an act of the State Legislature (the Act) designed to promote industry and develop trade by inducing manufacturing, industrial, governmental and commercial enterprises to locate in or remain in the State. Pursuant to the Act, the Authority is governed by a board of commissioners appointed by the governing body of County Y.

PLR 200022028: Request for a ruling that (1) income derived from the Corporation as a result from its proposed activities will be excludable under I.R.C. 115, (2) the Bonds to be issued by the Corporation will be considered issued on behalf of the State under I.R.C. 103 and (3) the Corporation is an instrumentality of the State under I.R.C. 141. Corporation was created by act of the State legislature as a subsidiary of the Authority. The Corporation has the power to issue bonds on behalf of the State for certain projects. The Authority was specifically created by the Act as an instrumentality of the State, with the power to perform such governmental functions as issuing bonds. The Authority was a valid “constituted authority” under Rev. Rul. 57-187. The members of the Corporation’s board are the members of the Authority’s board. The Bond proceeds were going to be used by a Company to develop and construct a destination resort on property anchored by a theme park. As a condition to receiving the ruling regarding on-behalf-of issuer status, the Authority and the Corporation had to amend their bylaws to provide the State with direct control over the Corporation. The point of this PLR is that there may not be stacking of on-behalf-of issuers. This concept may be equally applicable to instrumentalities such that stacking of instrumentalities is not valid. (Wir)

Advice Memorandum AM-2014-005 (Jun. 18, 2014): An Indian tribal government that receives an allocation of volume cap to issue tribal economic development bonds may designate an “on behalf of issuer,” within the rules applicable to bonds issued under I.R.C. 103, that is formed under the laws of that tribal government to issue those bonds. The proceeds of any bonds issued by such an “on behalf of” issuer will be treated as if they were proceeds of bonds issued by the Indian tribal government that received the allocation. See Notice 2009-51.

PLR 201442037: Income derived by authority created by Agency and County to manage water matters is income derived from exercise of essential governmental function and will accrue to state or political subdivision thereof for IRC § 115(1) purposes, and the Authority is a constituted authority for purposes of Treas. Reg. 1.103-1(b).

TAM 200646017, August 1, 2006: Michigan Charter School. Based on the facts relating to Michigan state law, the charter school is considered an on-behalf-of issuer.

2.2. “On Behalf Of” Issuers: 63-20 Corporations

63-20 Corporations are typically used where applicable state law has not specifically authorized the formation of public corporations which would qualify as constituted authorities under Rev. Rul. 57-187.

The criteria required for constituted authorities under Rev. Rul. 57-187 and the five requirements for 63-20 corporations are substantially the same. The most significant difference is the type of authorizing statute under which each is organized.

Rev. Rul. 54-296 (superceded by 63-20): Bonds issued by the nonprofit are deemed as having been issued on behalf of the lessee/user of the facilities during the life of the bonds and would become owner of the facilities thereafter.

Rev. Rul. 59-41(superceded by 63-20): Similar to 54-296, but now it was permissible even if the facilities not actually used by the political subdivision so long as the facilities were seen as public in nature (in the sense that the political subdivision might otherwise be required to provide them and could therefore be viewed as having been relieved of a burden rightfully belonging to it, i.e. Water and wastewater facilities).

Rev. Rul. 63-20: Involved a nonprofit corporation issuer who was not the owner and operator of the facilities but was to be a conduit. Must show the following to establish a 63-20 issuer (as clarified by 82-26):

Corporation must engage in activities that are essentially public in nature;

Activities and purposes of the corporation are those permitted under the nonprofit law of the state; and

Property to be provided by the corporation’s bonds must be located in the geographical boundaries of or have a substantial connection with the governmental unit on whose behalf the obligations are issued;

Corporation must be a nonprofit, except to the extent of retiring indebtedness (Corporate income must not inure to any private person);

Organized under nonprofit laws of the state in which the governmental unit is located; and

Articles of Incorporation provide that corporation is one not organized for profit;

State or political subdivision must have a beneficial interest in the corporation while the bonds remain outstanding, and upon retirement of the bonds, it must obtain full legal title to the property of the corporation with respect to which the bonds were issued;

Refers to interest in the bond-financed property, not in the corporation, and can be established by the following:

Purchase option at any time (can be compatible with customary 10 year call protection);

Purchase option in event of default;

Declaration of beneficial interest (file declaration in real estate records to put the “world” on notice);

Governmental unit has exclusive beneficial use equivalent to 95% or more of fair rental value for life of obligations; OR nonprofit has exclusive beneficial use equivalent to 95% or more of fair rental value for life of obligations and governmental unit appoints or approves the appointment of at leat 80% of the members of the governing board of the corporation and the power to remove, for cause, either directly or indirectly or through judicial proceedings, any member of the governing board and appoint a successor; OR Governmental unit has the right at any time to obtain unencumbered fee title and exclusive possession of the property financed by the bonds, and any additions to that property by placing in escrow an amount that will be sufficient to defease the obligations and paying reasonable costs incident to the defeasance (This is described in more detail in 82-26)

Full legal title requirement customarily provided for by having the corporation deposit a warranty deed and bill of sale with the bond trustee together with an irrevocable letter of instructions to deliver these documents to the political subdivision when the bonds are retired;

Financing of equipment may require statement in indenture by which borrower must maintain, renew, repair and replace the equipment so that fully equipped and operational facility exists at the time of the gift;

Full legal title means unencumbered title;

No delay in gift;

Must have level debt service schedules;

Cannot finance working capital or intangible property, because this negates gift effect;

Corporation must have been approved by the state, or a political subdivision thereof, either of which must also have approved the specific obligations issued by the corporation;

Customarily fulfilled by the adopting of a resolution of the governing body of the political subdivision prior to the issuance declaring the proposed financing by the nonprofit corporation will be beneficial to the political subdivision and agreeing to accept a gift of the bond-financed property (without binding the governing body at the time of such tender to accept the gift).

May be necessary to show legal reasoning supporting conclusion that political subdivision has the power to accept gifts of the type proposed to be financed. Do not need to show that the political subdivision could have issud for that purpose or has the power to operate.

[Only one “sponsoring” political subdivision.] Some bond counsel may disagree with the authority underlying this requirement;

No stacking of “on behalf of” entities.

Rev. Rul. 82-26: Clarifies elements of 63-20.

PLR 7605210220A (May 21, 1976): Community Hospital issues bonds on behalf of County to finance improvements to a hospital, and to acquire a hospital facility. The financing is structured to comply with 63-20, but there are issues regarding fair market value determination and management of the facility that are discussed in the PLR.

PLR 7742055 (Jul. 22, 1977): Proposed notes to be issued by nonprofit 501(c)(3) “Association” for hospital construction are considered issued “on behalf of” the City – a political subdivision. The Association and the City entered into a lease that provides that title to all buildings and improvements located on the leased land will vest in the City upon completion of their construction or annexation to the property. The lease also provides that it will terminate immediately upon the repayment of the Notes or the City’s paying the Association all necessary funds to pay or provide for all amounts due under the Notes. The City’s health officer is an ex-officio member of the Association’s Board of Directors. The analysis is a type of 63-20 analysis.

C. IRS PUBLICATIONS

IRS PLR 200923005, February 9, 2009: Authority created by statute to implement solid waste systems that has the power of eminent domain and whose directors are appointed by governor or legislative leaders qualifies as a “political subdivision” under Section 1.103-1(b).

IRS PLR 200837004, September 12, 2008: (1) Authority is a political subdivision of the State for purposes of Section 103 of the Code, because the Authority has been delegated the right to exercise sovereign power, is controlled by the State and is motivated by a wholly public purpose, and (2) Corporation’s income is excludible from gross income under Section 115(1) of the Code because the Corporation’s income is derived from the exercise of an essential governmental function and will accrue to a state or political subdivision thereof for purposes of Section 115(1).

IRS PLR 201104020, January 28, 2011: An authority created by state statute found (1) not to be a political subdivision because it didn’t possess enough sovereign power and (2) not to be an on-behalf-of issuer under Rev. Rul. 57-187 because the governing body of the entity was not controlled by a political subdivision.

D. OBLIGATION STATUS

1. Examples in Colorado

School districts. A school district in Colorado is a “school district, political subdivision and body corporate of the State.” As an express political subdivision of the State, it is a valid issuer for federal income tax purposes. Obligations of school districts are valid bonds under state law for federal income tax purposes based on either of the following statutory authorizations:

Pursuant to article 42 (Bonded Indebtedness) of title 22 (Education) of the Colorado Revised Statutes, as amended (“C.R.S.”), a school district may issue general obligation bonds, subject to voter approval of a ballot issue authorizing the bonds;

Pursuant to the Public Securities Refunding Act set forth in article 56 (Public Securities Refunding Act) of title 11 (Financial Institutions), C.R.S., a school district (as “public body” within the meaning of C.R.S. 11-56-103(7)) may issue general obligation bonds to refund outstanding general obligation bonds (principal and interest in arrears or to become due), subject to certain limitations and conditions (e.g., the underwriter must provide certain disclosures regarding financial matters, and the refunding bonds must be issued for certain permitted purposes).

Charter schools. In Colorado, a charter school is typically created as a Colorado nonprofit corporation pursuant to the Charter Schools Act set forth in article 30.5 of title 22, C.R.S., and a charter contract considered and approved by the local board of education of the applicable school district or the state’s chartering institute – the State Board of Education. A charter school in Colorado usually has no sovereign powers (and is therefore not a political subdivision of the state), and is not established by statute (and is therefore not a constituted authority). It is not entirely clear whether a charter school, the board of which is not elected or controlled by the state or school district, can nonetheless be considered an on-behalf of issuer. Some bond counsel have determined that the totality of the circumstances may determine status of the bonds as governmental versus private activity bonds – one significant factor being whether the charter school’s property is transferred to the school district when the charter school is dissolved.

See PLR 201217025 regarding a discussion of a charter school’s obligation to file a Form 990 even though the charter school is also a governmental unit. The IRS describes certain factors indicating control by a governmental entity.

Section 148(f)(4)(C)(vi) of the Code defines “Available Construction Proceeds” as the amount equal to the Issue Price (within the meaning of section 1273 and 1274) of the Construction Issue, increased by earnings on the issue price, earnings on amounts in any reasonably required reserve or replacement fund not funded from the issue, and earnings on all of the foregoing earnings, and reduced by the amount of the issue price in any reasonably required reserve or replacement fund and the issuance costs financed by the issue.

This means, the calculation includes earnings on the portion of the proceeds deposited to the 4-R fund (because those proceeds are part of the “Issue Price”) even though such proceeds are not in the actual construction fund.

General Matters

Interest on “arbitrage bonds” is not eligible for tax-exemption. Section 148(a) defines an “arbitrage bond” as any bond issued as part of an issue any portion of the proceeds of which is reasonably expected (at the time of issuance) to be used directly or indirectly (a) to acquire higher yielding investments or (b) to replace funds which were used directly or indirectly to acquire higher yielding investments. Bonds are also “arbitrage bonds” if the issuer intentionally uses any portion of the proceeds of the issue of which the bonds are a part to acquire higher yielding investments or to replace funds which were used directly or indirectly to acquire higher yielding investments.

Yield Restriction for Project Funds

A project fund usually qualifies for unrestricted investment during a three-year temporary period for capital projects. See required expectations to be made on the issue date. Capital projects do not include working capital items such as payment of employee salaries or other operating expenses. An issuer that reasonably expects to meet the requirements for the three-year temporary period but actually does not make the necessary expenditures in time will generally need to make yield reduction payments under Treas. Reg. 1.148-5(c)(3)(i)(A). An issuer would be well-advised to engage a rebate analyst to monitor spending for purposes of the yield restriction rules as well as for the spend-down requirements of any available exceptions to arbitrage rebate.

There are several temporary periods that apply instead of the three-year temporary period for capital projects. These temporary periods are:

Five-year temporary period if the issue is to finance a capital project involving a substantial amount of construction expenditures on a complex construction project. Certain certifications are required for this period.

Investment proceeds, defined as income from the investment of proceeds, have a temporary period of one year from the date of receipt.

Proceeds held to pay working capital expenditures, defined generally as operating expenses, have a temporary period of 13 months.

Yield Restriction for Costs of Issuance

The three-year yield restriction temporary period (described in Section 1.148-2(e)(2)) applies to amounts used to pay costs of issuance, which are considered “capital costs.” This is in addition to amounts used to pay project costs (conventional capital costs of the project). Costs of issuance are specifically excluded from the technical definition of restricted working capital expenditures under Section 1.148-1(b) (and see Section 1.148-6(d)(3)(ii)(A)(1) and Section 1.148-2(e)(3)), which have a separate, 13-month temporary period (i.e. that 13-month temporary period does not apply). See Frederic L. Ballard, Jr., ABCs of Arbitrage 27; Treas. Reg. Section 1.148-2.

The following costs are generally not considered “issuance costs”: Fees allocable to qualified guarantees, attorneys’ fees that are being incurred by the provider of a qualified guarantee in connection with the provision of the guarantee for the bonds (i.e. LOC counsel), mortgagee policy fees incurred by the conduit borrower in connection with obtaining the loan of bond proceeds.

Yield Restriction for Capitalized Interest

The three-year yield restriction temporary period also applies to capitalized interest.See Frederic L. Ballard, Jr., ABCs of Arbitrage 26; Treas. Reg. Section 1.148-6(d)(3)(ii)(A)(3). Generally, the three-year period applies to proceeds used for a “capital project.” A capital project includes “related” expenditures for working capital listed in the accounting regulations. Such related expenditures include “interest on the issue for a period commencing on the issue date and ending on the date that is the later of three years from the issue date or one year after the date on which the project is placed in service.”

Yield Reduction Payments after Three-Year Period

An issuer may reasonably expect to spend proceeds in three years and then fail to spend them because of unexpected problems related to the project. The failure to spend the proceeds in time does not invalidate the issuer’s use of the three-year temporary period, and it does not cause the bonds to become arbitrage bonds. Instead, the proceeds are simply subject to yield restriction after the three-year period. The regulations permit the issuer to make yield reduction payments to comply with the yield restriction requirement. The materially higher yield to test the yield on the proceeds is the 0.125% yield spread.

Rebate Funds

The Code and Regulations do not require the use of a rebate fund. The payment of required rebate can be accomplished from any source of payment, including principal of bond proceeds, from accumulated investment income in the rebate fund or else in any other fund, from operating revenues, or from any other source. If the rebate requirement is paid from bond proceeds, of either the issue to which the fund relates or some other issue, the payment will not be treated as a use of proceeds to pay operating expenses, for purposes of the rules providing that issuers may not allocate bond proceeds to payment of operating expenses, if there are other non-bond funds that could be used to make the payment.

Mr. Ballard states that the Regulations are silent concerning the eligibility of a rebate fund for unrestricted investment. He explains that most counsel appear to regard a rebate fund as a form of reasonably required reserve fund, eligible for unrestricted investment on that basis provided that the regulatory limits on the size of a reasonably required reserve fund have not been fully used up by the “regular” debt service reserve fund. If the regulatory size limits have already been reached, counsel can often reach the same practical result by treating the rebate fund as qualifying for yield reduction payments.

Abandonment of Project

Assume on the issue date the issuer reasonably expects to spend the project fund moneys within three years. Unexpectedly, the issuer cannot complete the project and, after five or six years, the issuer comes to bond counsel and requests advice on how to use the remaining project fund moneys. Bond counsel should advise the issuer that moneys in the project fund may be used for another good purpose or should be used to redeem bonds in the amount of the remaining project fund moneys. If redemption of the bonds is not possible immediately, the issuer may retain the moneys until the call limitation has ended. There are no requirements similar to the remedial action defeasance rules with respect to excess project fund moneys for governmental bonds.

See Rev. Proc. 79-5 (Jan. 1, 1979) regarding excess bond proceeds in the context of private activity bonds. Under the procedure, the excess bond proceeds must be used to redeem the outstanding bonds or establish an escrow for redemption.

Minor Portion

Under I.R.C. 148(e), “proceeds” may be invested in higher yielding investments as long as the amount invested does not exceed the lesser of:

five percent of the proceeds of the issue (i.e., threshold is $2,000,000 in proceeds); or

$100,000.

Minor Portion

The arbitrage of the minor portion is, however, subject to rebate. Prior to enactment of I.R.C. 148(e), the regulations allowed up to 15 percent of the proceeds of the issue, net of amounts in reserve funds, to qualify as a minor portion. The minor portion allowed by I.R.C. 148(e) is in addition to a reasonably required reserve fund.

Note that the Code states that the minor portion applies to “proceeds,” which would not include replacement proceeds. Treas. Reg. 1.148-2(g), however, clarifies that the minor portion rule applies generally to “gross proceeds,” which does include replacement proceeds.

Calculating Yield

Issue: The IRS used to permit “yield burning” as a method for reducing the yield on investments to stay within yield restriction limits. Investment providers benefitted from this “burning” by keeping the spread between the payment to the issuer and the sale in the market. Such burning was also possible by charging inflated administrative costs. Based on policy considerations, the IRS decided to prohibit yield burning. The following regulations were implemented as a result.

Basic Rules: The value of an investment (including a payment or receipt on the investment) on a date must be determined using one of the following valuation methods consistently for all purposes of section 148 to that investment on that date:

Plain par investment: A plain par investment may be valued at its outstanding stated principal amount, plus any accrued unpaid interest on that date.

Fixed rate investment: A fixed rate investment may be valued at its present value on that date.

Any investment: An investment may be valued at its fair market value on that date.

The third basic rule above is the default rule. Fair market value is defined in section 1.148-5(d)(6) to mean “the price at which a willing buyer would purchase the investment from a willing seller in a bona fide, arm’s length transaction. Fair market value generally is determined on the date on which a contract to purchase or sell the nonpurpose investment becomes binding […]. Except as otherwise provided in [paragraph (d)(6) of such section], an investment that is not of a type traded on an established securities market, within the meaning of section 1273 [of the Code], is rebuttably presumed to be acquired or disposed of for a price that is not equal to its fair market value.” Section 1273 of the Code is not particularly helpful in understanding how “securities market” is defined, but in many cases, it will probably be quite clear when an investment involves a securities market, and when it does not.

Example: Issuer invests bond proceeds in bank’s money market fund and makes periodic withdrawals to pay for the project. If this is a regular money market fund that depends on the amount put in and acts like a checking account, and if this type of account is available to anyone and not just users with tax-exempt bond proceeds, no special safe harbor with respect to investment valuation is needed – the fair market valuation rule applies.